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Today's Credit Opportunities in 5 Charts

How can credit markets help active investors achieve their goals in the present low yield environment? Here are 5 ideas.

In addition to being a human tragedy, the COVID-19 pandemic has accelerated existing structural trends and created new disruptions to the way we live and the world we live in. These macro changes are producing winners and losers, creating potential value for active investors as the dispersion of returns between sectors, credit qualities, and regions increases. Here are five credit ideas and charts that help illustrate the opportunity:

1. The search for yield

The monetary policy response to the pandemic has been unprecedented in size and scale. Rate cuts intended to stimulate the economy have brought global yields lower and, as of the end of November 2020, over 25% of global fixed income assets were negative-yielding. This means that investors looking for positive yield may have to increasingly move down the risk spectrum and towards credit for their income needs. Indeed, there have been significant inflows into credit mutual funds so far this year.

Chart 1: The search for yield may drive demand for credit assets

This line chart shows the percentage of securities within the global bond market (by market value and proxied by the Bloomberg Barclays Global Aggregate Index) that offered negative yields over the time frame 2009 to 2020. After hovering at or near zero until 2014, the percentage rose above 25% in 2015, then fell slightly, and then rose again to a peak of 30% in 2018. The percentage remained relatively high at 27% as of December 2020. China was the first country affected by the COVID-19 pandemic, and also the first to recover: PIMCO forecasts that by the end of 2021, Chinese Gross Domestic Product (GDP) will be almost 15% above its 2019 level. This contrasts with U.S. GDP, which is likely to have only just reached its pre-pandemic levels. At the same time, and given prospects of a weaker U.S. dollar in 2021 and a “lower-for-longer“ interest rate environment, we expect inflows into emerging market (EM) Asia credit to continue. Finally, valuations for Asia credit may be attractive: The spread premium relative to U.S. credit is currently near three-year wides, as seen in the chart.

Chart 2: Credit spread premium for Asia credit vs. U.S. credit

Chart 2: This line chart compares the option-adjusted spreads between Asia credit markets and the U.S. credit market for both investment grade and high yield corporate bonds over the time frame November 2017 to November 2020. The investment grade spread averaged around 42 basis points over that time frame, but stood at 60 basis points as of November 2020. Over the same time frame, the high yield spread averaged around 110 basis points (but fluctuated more widely over time), and was near 300 basis points as of November 2020.The pandemic has affected different sectors unevenly. Technology, for instance, has rallied as our ways of working and consuming have become more digital, while sectors like hospitality and travel have been severely hit due to lockdown measures. Significant fiscal and monetary intervention has helped tighten credit spreads from the extreme levels seen in March 2020, but some sectors, especially those worst hit by the recession, are still far from their pre-pandemic levels. With vaccines in deployment and the economic recovery expected to continue, spreads in these hardest-hit sectors may be poised to outperform and offer further upside, particularly among more resilient issuers that have ample liquidity.

Chart 3: COVID-affected sectors have generally underperformed more defensive sectors in 2020

Chart 3: This bar chart lists 37 separate sectors within investment grade credit sectors and shows for each sector the spread, in basis points, between the widest and tightest spreads above like-maturity U.S. Treasuries for that sector during calendar year 2020 (through November). The sectors most affected by the COVID-19 pandemic displayed the widest range in spreads, with nearly 200 basis points for airlines, 118 basis points, for leisure and around 100 basis points for lodging and gaming.This year’s economic contraction increased the number of downgrades from investment grade (IG) ratings to high yield (HY) (known as fallen angels) to levels last seen in 2015–2016 after the plunge in global oil prices. This also meant that there was far more debt in the lowest IG bracket (BBB and BBB−) on downgrade watch by a rating agency than there was HY debt in the highest HY bracket (BB and BB+) being considered for an upgrade. The situation, however, has reversed now: For the first time in 13 years, and on the expectations of an economic recovery, over the near term there is more HY debt that could be upgraded (known as rising stars) than IG debt that could be downgraded, as seen in the chart.

Chart 4: More upgrades than downgrades?

Chart 4: This bar chart shows the difference in notional value between debt rated BBB or BBB− that is on downgrade watch by at least one credit rating agency and debt rated BB or BB+ that is on upgrade watch. The chart covers the time frame of Q4 2008 through Q4 2020, during which the notional value of the BBB/BBB− (investment grade) debt on watch was greater than that of the BB/BB+ (high yield) debt on watch in all quarters except Q4 2020. The difference reached as high as $167 billion but usually ranged between $25 billion and $85 billion.U.S. high yield defaults spiked in April and May 2020, when an earnings slowdown resulting from global lockdown measures and collapsing oil prices hit weaker issuers within the asset class. Defaults, however, have gradually declined since then. As the economic recovery continues, defaults are likely to continue to decline, although they may remain elevated vs. long-term averages into 2021, highlighting the importance of active management and security selection.

Chart 5: Defaults: good news in the bad news

Chart 5: This bar chart shows the volume (by face value) of defaults in U.S. high yield markets each quarter in 2020 (Q4 data is through 30 November). In Q1, the volume was $5 billion, but in Q2 it spiked to $47 billion before dropping to $18 billion in Q3 and just under $5 billion in Q4 through 30 November.Source: BAML as of 30 Nov 2020. Chart shows quarterly defaulted debt in the ICE BAML US HY Index. Volume figure includes distressed exchanges.

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Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.  High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

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Outlook and strategies are subject to change without notice.

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